Central Banks Digital Currencies and Blockchain.

Everyone wants to get in on the conversation. Everyone wants to play a part in building the technology, the payment system of the future. But all they are really doing is speculating. They are all putting their self-proclaimed ‘crypto expertise’ to the task, whereas in reality, it is just partial, incomplete knowledge misguiding the people. Therefore, we do not blame you if you are confused on the topic of digital currencies, decentralization and/or blockchain.

Let us clear that up for you.

Digital currencies are exactly what the name suggests- a medium of exchange of assets over a device like a computer. There is no physical movement of banknotes or coins involved in the transactions. It exhibits similar properties to physical money but allows for immediate transactions and borderless transfer-of-ownership. It can be used to purchase goods and services normally but may be restricted in some cases.

As is the case explained in further articles, digital currencies are not yet accepted by banks, due to the risks they pose, and as a result, interest on them cannot be earned as of now.

Central banks are not completely opposed to an idea of digital currencies and could be looking to launch a centralized version of these currencies known as central bank digital currencies. They will have all the features of the digital currency, in addition to being controlled and regulated by a power such as a central bank of a country. They will be universally acceptable and distributed through technologies such as distributed ledgers. The interest-bearing part is up for debate, with the IMF refusing to define CBDC’s as interest bearing. Therefore, we could certainly see something such as central bank digital currencies and blockchain in the near future.

Is the world ready for digital currencies?

Apparently not, if the world’s leading economies are to be believed. China has straightforwardly said the technology behind digital currencies simply cannot be used in their economy, in their underlying currencies. The Bank of Japan states that digital currency will not replace physical money anytime soon, believing that it is ‘too far off’ right now and ‘would change the banking system drastically’.

The US Federal Reserve’s early investigations into bitcoin have led them to believe that privacy issues will be a problem and that private sector alternatives will do the job pretty well. The European Central Bank appears to think of the crypto boom as nothing but a bubble, saying its links to tax evasion and crime are major risks.

The United Kingdom seems to be in favor of such a technology. Bank of England admits that cryptocurrency could be a part of a financial revolution and that the technology shows great promise. Similarly, the Brazilian Central Bank also believes digital currency and the technologies to be potential innovations in the finance sector, albeit being beware of the risks posed by it.

Now, we don’t blame economies for being skeptical to the use of digital currencies. It is still an untrusted and unproven method of exchange. The technologies that power it, blockchain included, still are in nascent stages.

One nation that set itself apart from the major countries on this issue in Estonia. Very recently, Estonia has announced plans of releasing its own digital currency, Est-coin, which will operate on the already established country blockchain. It will, therefore, be classified as a central bank digital currency using blockchain. It will most likely be accepted by all major merchants and will integrate seamlessly with the digital services already on offer.

One interesting plan of action that can be considered is the existence of a multi-economy digital currency, issued, for instance, by the European Central Bank. As is the case with the Euro, it would be regulated by a central body but would make transactions across borders way easier due to the uniformity of a single currency, which implies no exchanging hassles and no conversions needed. The central body can then lay out appropriate laws and protocol to manage this system.

A bit on bitcoin

Bitcoin was the very first decentralized cryptocurrency ever produced. Decentralized means that it works without an administrator, a governing body, such as a central bank. Therefore, it is largely different to a central bank digital currency, although it does use blockchain. Transactions between individuals or consumers take place directly, without the interference of a middle party such as a bank.

What is a blockchain?

Blockchain basically means a public network, in which all the activities happening on the network is recognized and saved by each node on the network. To explain it better, let us take an example.

Suppose there is a network of 10 people, who transact in bitcoin. One of these 10 people has to pay another person a certain amount of bitcoin. When the transaction is made, a unique transaction ID is generated, using complex computing algorithms, this ID can now be used to track the payment. Moreover, this ID is also accessible to each and every one of the 10 persons of the network. They will also be able to see where the other person spends the bitcoin.

This is the basic structure of blockchain, which powers the Bitcoin network.

Why bitcoin, though?

This cryptocurrency was developed to be a decentralized one, to bring trust back to the market. As there are no middlemen required in transactions, bitcoin aimed at enabling individuals to directly pay and accept money from each other. It is generated through a process called mining, which is solving complex mathematical problems on a high power computer device in exchange for generating bitcoin.

The boom of the bitcoin has caused a huge upturn in the talks of digital currencies. As defined earlier, digital currencies remove the physical aspects of movement of money involved in the transactions.

Why is digital currency being discussed so desperately?

Well, not without good reason.

One of the biggest advantages of digital currency is that it affords anonymity. Personal information attached to credit cards and debit cards can be accessed easily by banks whenever they are swiped. There is no such scene with digital currencies. One more advantage is no chance of frauds and lower transaction fees. No chargebacks or the sort is possible with digital currency transactions, and there are little to no transaction fees. Thanks, internet.

Central bank digital currencies and blockchain essentially have all the features of the digital currencies, just that they are regulated by a governing body.

What powers the digital currencies?

Certainly, if cryptocurrencies such as bitcoin have become so immensely powerful, there must be something equally powerful behind them? There is.

All the major crypto and digital currencies of the world rely on the blockchain, a brainchild of the founders of the bitcoin, Satoshi Nakamoto. In lay man’s terms, blockchain can be pictured as a database duplicated on to thousands of computers and continuously updated. This is the absolute basic understanding of how a blockchain works.

According to Wikipedia, it is defined as a continually growing list of records called blocks, which are linked and secured using cryptography. Each block typically contains a hash of the previous block, transaction details, and a timestamp. This property of a blockchain enables it to be used for transaction purposes, hence the bitcoin being powered by it.

Blockchains are basically built from 3 technologies.

Private key cryptography

The p2p network

The program(protocol)

The result of the amalgamation of the three is a network that does not need a central, trusted third party to function. Hence, digital currencies and blockchains are classified as decentralized. However, governments can maintain regulation over such currencies by using the aforementioned concepts of central bank digital currencies and blockchain.

What happens in a blockchain? What’s the procedure?

When two entities wish to transact over a network, a complex series of events takes place. Every entity has its own private key and a public key. It is the combination of these two keys that comprises of a digital signature, which can be seen as a proof of identity and a form of consent.

Now, while authentication is important, it has to be complemented by a method to approve transactions. Here is where the distributed network nature of blockchains comes into play. They mathematically verify the transactions taking place on the network. This is the thing that gives the blockchain network its value. The amount of computing power afforded to this network ultimately dictates its security. For example, bitcoin is secured by 3.5 million TH/s, more than the 10000 largest banks of the world combined.

When one person transfers data or currency to another, the same information is relayed across the network and is recorded on every node of the network.

The data being broadcast on the blockchain must be unique in nature. This means that a copy of the same data must not be used in separate transactions at the same time. Its application lends itself to mining in bitcoin, as computers on the network seek to verify the integrity of the network, of each bitcoin by solving complex mathematical problems. When a majority of miners reach a consensus over a certain block of information, it is timestamped and added to the network.

A live example-Bitcoin

Bitcoin, as discussed earlier, works on blockchain technology itself. The transactions are recorded on all nodes across the network, with each node collecting transactions and forming a block. Transfer of coin takes place by the owner of each coin digitally signing a hash of the previous transaction and the public key to the next owner. The payee can verify ownership of the coin by validating these digital signatures.

The uniqueness of data on a blockchain comes into great use here. Here, the data is a coin, and it must be a single transaction coin, that is, it must not be used in multiple transactions at the same time. This ensures that nodes cannot just create infinite copies of the bitcoin and use it wherever they want. To verify that a transaction is permitted or not, all the nodes on the network try to find out a rigorous proof-of-work of the transaction. When a node does so, it relays the block under consideration to all other nodes. If all the nodes on the network accept the proof of work, they create the next block in the chain, which, according to protocol, starts a coin issued in the name of the owner of the block.

This is the method of generating bitcoin, as there is no central authority to issue them. Once a pre-decided number of coins enter circulation, transaction fees and other incentives can be imposed to make the coin stable and inflation-free. This also encourages nodes with higher CPU power than others to stay honest and play by the rules.

So, we can see that blockchain technology is quite the hype right now, due to the breakthroughs in technology world caused due to it, and the boom of the bitcoin giving it added reliability as a system to be used for digital currencies.

Is it a one-horse race?

Not only blockchain, several other technologies have also entered the digital currency sector. These are very promising and may even be able to outperform the blockchain that exists currently. For instance, a digital currency by the name of IOTA has enjoyed a huge rally in 2017. Its value has more than doubled in the past year, and it runs on a technology completely different to blockchain.

The creators of IOTA believe that blockchain transactions are too costly, so they decided to build their own system. Based on the mathematical concept of a directed acyclic graph, they have built what is called a ‘Tangle’. This dispenses with the ‘miners’ or the nodes require to validate transactions in blockchain.

The process is that when a user issues a transaction, he/she validates two previous transactions, and they, in turn, validate 4 more. This creates a web of transaction verifications that confirms, in due time, all transactions on the network.

High profile tech giants such as Microsoft, Fujitsu and other believe that IOTA may be on to something. It is still in a beta stage, however, but the promise shown by this alternative to blockchain is very intriguing.

On the world front, China, even though it has banned cryptocurrencies like the bitcoin, is looking to develop its very own central bank digital currency. This, they believe, would bring down transaction costs and speed up research and issuance. They are looking to move away from the blockchain to power it, instead of using technologies like big data, artificial intelligence, and machine learning to run their very own centralized digital currency.

So, what’s the final call?

Digital currencies might as well be “the” currencies of the future. This concept and the technology behind it is being constantly worked on to make it better and more widely accepted. Banks and economies are taking a more open-minded view towards the innovations happening in this sector. They are looking to introduce controlled central bank digital currencies and blockchain and other technologies. The cryptocurrency boom can only be taken as a positive sign of what the future holds for this sector. Who knows, maybe one-day digital currencies become a norm instead of an anomaly?

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